Discover It: More about subprime crisis and consequences

"Developing a new risk paradigm” is an excellent article written in today’s ET by TK Arun. A must read for those who want to understand the play of subprime crisis on developing countries’ economies.

It gives an excellent explanation of how the crisis started.

· The subprime crisis started with lenders in the US pushing home loans to people who just didn’t have the capacity to service them.

· These unviable loans do not stay on the books of the lenders for long. They are securitised and sold off to other investors in various esoteric combinations. How risky these instruments were, the investors didn’t have a clue — they chose to swallow the triple A rating the credit rating agencies gave them and bought them up by the tonne anyway.

Some other questions that are answered in straight-forward manner by this article include the following.

What adverse affects were played out by the subprime crisis?

· When interest rates went up, as the Fed raised rates to combat inflation, default on these loans began. Worse, fears of large-scale default began to mount. And defaults on loans lead to mortgage foreclosures, bringing houses on to the market.

· House prices have not just stopped soaring in the US, but also started declining, as more and more houses come up for sale. The drop in house prices makes the outstanding loans riskier still — the loan-to-house-value ratio goes up. If the loan against a house is larger than the market price of the house, even foreclosure will not prevent loss. So, the closer the value of the loan approaches the value of the house, the riskier the loan.

What is a ‘flight to safety’ manoeuvre undertaken by FIIs and how does it hurt countries like India?

· When this perception of risk goes up, lending freezes up, throwing sand into the economy’s machinery. Further, funds undertake a manoeuvre called flight to safety. This is where developing economies like India get hurt. India, and such economies classified as emerging markets, are still seen by developed country fund managers as risky propositions. So the flight to safety will see some funds pull out of countries like India. This could lead to a stock markets slide in these economies, loss of confidence and slowdown of the real economy. This is one source of disruption.

· The other source of disruption is construction-led slowdown in the US. This could hit developing economies that export a lot to the US. Around 40% of Chinese exports, for example, go to the US. About 22%of Indian goods exports go to the US and a significantly larger share of India’s service exports.

You may also be interested in looking at what we noted on the subject earlier on: